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Exclusivity, Competition and the Irrelevance of InternalInvestment

*

by

Catherine C. de Fontenay, Joshua S. Gans and Vivienne Groves

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First Draft: 9

th

September, 2009This Version: 29

th

September, 2009

This paper considers the effect of exclusive contracts on investmentdecisions in a market with two upstream and two downstream firms. Segal andWhinston’s (2000)

irrelevance result

is generalized and it is shown that exclusivecontracts have no effect on the equilibrium level of internal investment for thecontracted parties when competition exists in both the upstream and downstreammarkets. Furthermore, by considering a more competitive environment we areable to demonstrate that strongly

internal investment by rival upstream-downstream bargaining pairs is similarly unaffected by the presence of exclusivecontracts.

Keywords

. exclusive contracts, irrelevance result, Shapley value, upstreamcompetition, bargaining.

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Responsibility for all errors lies with the authors. We thank participants at the EARIE conference 2009and Ilya Segal for helpful discussions. Financial assistance from an ARC Discovery Grant is gratefullyacknowledged.

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Melbourne Business School, University of Melbourne. All correspondence toJ.Gans@unimelb.edu.au.The latest version of this paper will be available atwww.mbs.edu/jgans.

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1.

Introduction

In 2007, Apple Inc announced the introduction of the iPhone in the United States. At thesame time, it announced that the exclusive carrier for the iPhone would be AT&T (thenCingular). One of the reasons cited was AT&T’s investment in enabling ‘visual voicemail’ (anew and potentially revolutionary way of accessing voicemails). That investment was specific tothe iPhone and required to enable the service. It had no value outside of the relationship betweenApple and AT&T – it was purely internal.The notion that exclusive contracts are utilized to encourage certain types of investment – particularly, specific ones – has been long-standing (Klein, 1988; Frasco, 1991). However, thisargument has been challenged by Segal and Whinston (2000). Their

irrelevance result

showsthat in a market with one downstream buyer, one upstream seller, and one upstream potentialentrant, exclusive contracts have no effect on the level of relationship-specific (internal)investment.

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In their model, firms’ payoffs are a function of their marginal contribution tofeasible coalitions. Segal and Whinston allow parties to exclusive contracts to renegotiate in theevent that both parties can be made better off if the contract is suspended and the downstreamfirm is allowed to trade with the incumbent. Exclusive contracts eliminate the payoff fromcoalitions which do not include the two parties to the contract, because the two parties cannotnegotiate to release each other from exclusivity. Investments, however, only raise the payoffs tocoalitions which

do

include both parties to the agreement, and so the increase in profits availableto investing parties is independent of whether exclusive contracts exist or not.Of course, the Apple/AT&T situation is one where there is competition both amongst phone manufacturers and mobile carriers. While the return to internal investment, in a marketwith a bottleneck firm in one segment, does not change when there can be renegotiation amongstthe contracted parties, the question is whether internal investment is similarly unaffected whenthere is an additional independent entity in the other segment. In an important generalization tothe Segal and Whinston environment, we demonstrate that the

irrelevance result

continues tohold in a market with both downstream and upstream competition. Moreover, we demonstratethat exclusive contracts signed by one upstream/downstream pair do not effect the strongly

1

Internal investment between two firms is defined as investment that only affects the payoff from bilateral trade between the investing parties, and does not affect the payoff from bilateral trade between any other pairs..

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internal

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investments of the other pair. Nonetheless, internal (or relationship-specific)investments between firms where only one firm is party to an exclusive agreement, or investments between rival pairs which are

not

strongly internal can, in fact, be altered by suchagreements.A critical input into our analysis is reliance on the

Generalised Myerson-Shapley value

asconstructed by de Fontenay and Gans (2005, 2008). This value arises out of a non-cooperative bargaining game – familiar in work on bilateral vertical contracting – that involves upstream anddownstream firms engaged in pairwise negotiations where contract terms are difficult to observe between negotiating pairs. Its usefulness is that it directs attention towards the graph of bilateralrelationships that are structurally possible within the industry. de Fontenay and Gans (2005)apply this to vertical integration whereas here we consider exclusive contracting. Significantly, itallows us to distinguish between one-sided exclusivity (whereby only one party is restricted in itsability to contract elsewhere) and two-sided exclusivity (where both parties are restricted). Thisis something that could not be analysed in settings where there was always a monopoly segmentin the market.The use of a Shapley-like bargaining solution has been criticized by de Meza andSelvaggi (2007). They provide an example of a Rubinstein bargaining game with delay, in whichthe outside option does not affect the division of surplus but may be “exercised” if it is preferredto the bargaining outcome. Under this non-linear structure, they can construct an example inwhich for some parameter values, one firm does not invest without an exclusive contract, because its bargaining position is so weak that it obtains its outside option.

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In contrast, the non-cooperative game in de Fontenay and Gans (2008) demonstrates that in negotiations, agents aredividing the surplus above their outside options, and thus outside options enter payoffs in a linear fashion. For the reasons explored in de Fontenay and Gans (2005, 2008), we argue that theGeneralised Myerson-Shapley value is a useful and natural representation of the outcomes of multi-lateral interactions along a vertical chain. Nonetheless, the baseline critique of de Mezaand Selvaggi (2007) – that certain bargaining games and some investments will negate the

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We define internal investment as strongly internal if the value of the investment is unaffected by the presence of other parties in the market.

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We do not discuss the remainder of their paper, which is based on the fairly unusual assumption that while theexclusive partners cannot agree to release each other from the contract, the downstream buyer can choose to re-sellthe supply to his competitor.

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Exclusivity, Competition and the Irrelevance of Internal Investment

This paper considers the effect of exclusive contracts on investment decisions in a market with two upstream and two downstream firms. Segal and Whinston’s (2000) irrelevance re... (More)

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